This column was contributed by Alex Greer.

When building out a long-term financial plan, a key consideration is tax efficiency. Before deciding on what investment account types are best for your unique financial situation, it’s important to understand the tax treatment of investment accounts. This article will break down common investment accounts and their tax treatment. 

Tax Treatment of Traditional 401ks/Traditional IRAs 

Traditional 401ks and IRAs are considered “pre-tax”; meaning that the money contributed to the account hasn’t been taxed yet. When contributions are made, the contribution is deducted from taxable income in that tax year. The money grows tax defferred, and then is taxed as income when distributed in retirement. For example: Hypothetical example for illustrative purposes only. 

•  If a worker who earns $250,000 a year makes a maximum contribution of $23,500 to their 401k, taxable income will be reduced to $226,500. Once the money is in the account, it grows tax-deferred, meaning that there is no tax on the growth in the account, including dividends and interest paid out. Eventually, when this worker retires, any distribution from the account will be fully taxable as income. If the worker distributed $100,000 from the 401k in retirement, the full $100,000 would be taxed at income tax rates. These retirement accounts are subject to contribution limits and other restrictions. 

Tax Treatment of Roth 401ks/Roth IRAs 

Roth 401ks and Roth IRAs operate slightly differently from the traditional versions. When contributions are made to these accounts, there is no tax deduction in the contribution year. Money grows tax deferred, and then can be distributed with no tax in retirement, as long as the 5 year holding rule is satisfied.  

• If we take the same worker who makes $250,000 a year and they contribute $23,500 to the Roth side of the 401k, taxable income will still be $250,000 in that year. The money in the Roth account grows tax-free, and distributions from the account are also tax free. If the worker were to distribute $100,000 from the account in retirement, there would be no tax bill associated with the distribution. These retirement accounts are subject to contribution limits and other restrictions. 

Tax Treatment of Brokerage Accounts 

Brokerage accounts, also commonly referred to as “taxable accounts,” have a different tax structure from the retirement accounts mentioned above. There is no tax deduction when contributing to a brokerage account, and once money is invested, growth is taxed each year. Dividends and interest paid in the account will be included in taxable income each year that they take place. When distributions are made from the account, the tax depends on the performance of the investments and the amount of time that the investment is held. Each time an investment is made, cost basis is assigned to note the amount paid. For example: Hypothetical example for illustrative purposes only. 

• If an investor bought 10 shares of Amazon (AMZN) at $200 per share, total cost basis would be $2,000. If, when the investor sells the shares, the stock is worth $300 per share, a full sale of the 10 shares would generate $3,000, and a $1,000 capital gain. No tax is paid on the $2,000 basis, but the gain is subject to capital gains tax. If the investment was held for less than one year, the $1,000 is subject to income tax rates. If the investment is held for more than one year, it’s considered a long-term capital gain and gets taxed at those rates. Long-term capital gain tax rates are either 0%, 15%, or 20%, depending on your income level. These accounts are not subject to any contribution limits. 

Tax Treatment of Health Savings Accounts 

Health Savings Accounts (HSAs) are becoming a popular way for employees to save money for healthcare costs in a tax efficient way. To contribute to an HSA, you must be enrolled in a high-deductible health plan. HSAs are subject to contribution limits, for 2025 the maximum contribution is $4,300 for self-only coverage. For example: Hypothetical example for illustrative purposes only. 

• If a worker contributes $4,300 to an HSA, that amount is deducted from income, similar to a traditional 401k. Dividends and interest are not taxed year over year, and if the money is withdrawn to pay for a qualified healthcare expense, it is not taxed when distributed. HSAs offer a rare triple tax advantage, in that they provide an immediate deduction, tax free growth, and tax free distribution. If an account owner pulls money from an HSA for ineligible expenses before the age of 65, there’s a 20% early withdrawal penalty plus income taxes, and state income taxes may differ by state. After age 65, there is no penalty for ineligible expenses, but the distribution does cause income tax. 

The Importance of Understanding Tax Treatment for Investment Accounts 

Understanding the tax treatment of investment account types is one piece of the financial planning puzzle. It’s important to think strategically about which accounts offer the best benefits for you.  

At Pathfinder Wealth Consulting, we offer personalized advice around the unique needs of each client situation, whether it’s deciding what account type to save into, or where to pull retirement income from. If you want to take the first step towards securing your ideal financial future, contact us today to schedule a financial planning consultation with one of our experienced Wealth Advisors! To learn more about how we work with clients and our fiduciary commitments to you, view our Form CRS Client Relationship Summary. 

This material is intended for informational and educational purposes only and should not be construed as specific investment, tax, or legal advice. Tax laws are subject to change and may vary depending on individual circumstances and state of residence. Hypothetical examples do not represent the experience of any specific client. Investment involves risk, including the possible loss of principal. Please consult with a qualified tax professional regarding your specific situation before making any financial decisions.